Dear Investor
General Market Overview
Over the quarter, only the Japanese Nikkei ended positively. Major indices, the S&P 500, FTSE 100, and French Cac, all fell around 3%. The technology sector dominant German Dax lost just under 10% for the quarter.
Central bank decisions, inflation, and a deepening energy crisis in Europe have dominated the market headlines over the quarter. More than 80 central banks have hiked rates since the start of 2022. Turkey is an exception to the global trend and in an unorthodox move, cut rates in August by 100bps from 14 to 13% despite inflation of nearly 80% y/y. As mentioned in previous reports, the Turkish Central Bank’s decisions are very much politically driven, with a looser monetary policy intended to support economic growth ahead of a general election next year.
Following the Federal Reserve (Fed) actions, the US yield is currently inverted, with the 10-year yield trading 35bps below the 2-year yield. In Germany, by contrast, there is no inversion, with the 10-year German yield trading 37bps above the 2-year yield. Interest rate expectations can largely explain the divergence in yield curves between the US and Europe. The market anticipates that the Fed is more likely than the European Central Bank (ECB) to raise interest rates. The Fed has already raised interest rates by 150bps in 2022, including a 75bps rise in July to 2.5%.
Historically, yield curve inversions have preceded recessions, with the 10-yr/1-yr curves having inverted before each recession since 1955. The recession followed between 6 and 24 months later with just one false signal. The 2/10 spread has inverted 28 times since 1900. In 22 of these instances, a recession followed. For the last 6 recessions, a recession, on average, began 6 to 36 months after the 2/10 curve inverted.
The macroeconomic environment has, understandably, affected foreign exchange markets. The US Dollar, which is one side of about 90% of all foreign exchange transactions, accounting for $6 trillion in activity every day, is having its best year thus far since 1997, as measured by the Dollar Spot Index. The Japanese Yen is at a 24-year low against the Dollar, and the Euro reached parity. The primary driver of US Dollar strength has been the expectation of further aggressive Fed tightening together with a “flight to safety” in the form of investor withdrawals from higher-risk emerging markets.
A stronger Dollar has an impact on global trade. Many developing economies are price-takers because their domestic policies and actions don’t impact global markets, and they are primarily dependent on international trade. As the Dollar strengthens, imports become expensive (in domestic currency terms), forcing firms to reduce their investments or spend more on crucial imports. While some export-led economies may be able to benefit as increased exports boost GDP growth and foreign reserves, across many emerging markets, a strong Dollar is a negative factor.
Likely to be most affected are countries where US Dollar debt represents a large portion of GDP. Paying interest to creditors in Dollars has become particularly difficult for countries with rapidly depreciating currencies like Argentina and Turkey, especially as interest rates on any new debt will also increase. It has become seemingly impossible for some, including Sri Lanka, which is currently facing total economic collapse.
The US Dollar is the dominant currency in global energy markets, which remain dominated by fossil fuels. Despite many green-energy aspirations, typically communicated by politicians, to switch to renewable sources of power, the reality is that the global energy mix is unlikely to change anytime soon. It is impossible to replace the reliance on gas, oil, and coal - a fact that many countries are now experiencing first-hand with dire economic consequences.
Increasing energy prices, particularly gas, are not just impacting European households. The fertiliser industry relies heavily on natural gas as a critical component of many types of fertiliser production. Natural gas represents 60-70% of fertiliser production costs, and with the parabolic rise in natural gas prices, fertiliser production across Europe is shutting down. Similarly, the glass industry is facing stress, and many European beer manufacturers are starting to stockpile glass beer bottles in anticipation.
Within the UK, household energy bills are forecast to rise even higher this winter, pushing millions into fuel poverty and threatening to cause a recession. Wholesale energy costs explain 96% of the jump in household bills from mid-2021 to 2Q 2023 (estimated figures).
UK consumer inflation accelerated to a four-decade high of 10.1% in July. Surging food prices (12.7% y/y) continue to intensify the country’s cost-of-living crisis. Citigroup has forecast that inflation in the UK will rise above 18% y/y over the coming months, pushed by gas prices. If inflation does hit 18%, this would be the highest level in almost 50 years. It is worth recalling that in 1976, the IMF had to bail out the UK because the UK Government could not issue Government debt to service existing debt due to a run on the Pound.
UK consumers are certainly feeling the pressure. The GfK Consumer Confidence indicator for the UK fell to a record low of -44 in August from -41 in July. Household budgets will likely become even more stretched into October as energy bills are projected to rise further.
The Bank of Japan (BoJ) has been fighting deflation in Japan for decades and has a core inflation target of 2% y/y. In July, Japan’s core CPI measure (which excludes fresh food) rose by 2.4% y/y, surpassing the BoJ’s target. However, the BoJ is unlikely to change its accommodative stance as the Japanese economic recovery has been slow. The more dovish positioning by the BoJ does make it an outlier amongst its developed market peers, all of which are raising rates aggressively. This monetary policy divergence has also contributed to the weak Yen, which is now very cheap on a purchasing power parity basis, having been heavily shorted by market participants over the year.
General Conclusion
As we anticipated last quarter, the macroeconomic environment presents a problematic climate for financial markets. Rising prices negatively impact households and businesses, particularly in the energy and food sectors. Inflationary pressures coupled with the response from central banks, in the form of rising interest rates, make it difficult to justify higher growth targets for the economy and market sectors.
There has been a withdrawal of liquidity from the markets as part of the central bank’s desire to curtail rising inflation within central bank targets. Together with the strong Dollar and rising US yields, these factors have fed into asset prices, particularly in more growth-driven sectors like technology and those areas of the market that require a higher risk appetite, such as emerging markets and higher yield debt.
13 September 2022